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Industrial REITs Experience Unprecedented Success

Bolstered by the surge in e-commerce, industrial REITs have become the belles of the industry ball.

Propelled largely by the e-commerce boom, industrial rents have grown more than 5.5 percent annually over the past two years in the top 50 U.S. markets, says Eric Frankel, lead industrial analyst at Green Street Advisors, a Newport Beach, Calif.-based firm. This year’s growth rate will be similar, despite more new supply coming on-line, he says.

“Besides Amazon, industrial REITs are perhaps best positioned to capitalize on the growth of e-commerce,” says Alex Pettee, president and portfolio manager of Hoya Capital Real Estate, an investment advisory firm.

The REITs benefiting the most from the e-commerce wave include Prologis, DCT Industrial Trust Inc. and Duke Realty Corp., industry observers say. The stock price of Prologis is hovering around levels not seen since its peak in 2007, while the stock prices of DCT and Duke are enjoying a several-year run-up.

Since 2010, rental rates for logistics-oriented warehouse space—the type of space that’s sought by e-commerce players—have more than doubled in the most desirable e-commerce markets, says Pettee, basing this estimate on quarterly earnings reports from Prologis. Meanwhile, stock prices for industrial REITs as a group have surged more than 70 percent in the past two years, according to the market-cap-weighted Hoya Capital Industrial REIT Index.

“The perception of industrial REITs has changed dramatically over the past three years,” Pettee says. “Before 2014, nobody wanted to talk about industrial real estate, and now it’s the hottest sector.”

Indeed, the investment momentum in the industrial sector has outpaced the overall commercial real estate market as investors have flocked to industrial holdings, according to a report from real estate services company JLL. During the first half of this year, investment sales in the industrial sector totaled $23.8 billion, according to the report.

E-commerce, logistics and distribution companies dominate leasing activity for new warehouses, the report says. Much of the demand for warehouse space stems from the fact that each item sold online requires three times more warehouse space than an item sold at a brick-and-mortar location, as the delivery speed called for in e-commerce produces significant inefficiencies, according to CNBC and Pettee. And that demand has created a vacuum of warehouse availability.

“Well-located industrial assets are the backbone of the logistics network, and e-commerce retailers are fiercely competing for space in these distribution centers,” Pettee says.

In light of the fierce competition, industrial rents reached an all-time high of $5.35 per sq. ft. in the second quarter of 2017, according to the JLL report, with annualized rents rising by nearly 6.6 percent. Throughout the rest of this year, industrial vacancy rates are expected to keep declining, the report notes.

“Industrial REITs don’t typically experience the boom-and-bust cycle, so we’re in unchartered territory here,” he says. “While supply growth has heated up significantly over the last several years, the lack of available land to build well-located distribution facilities continues to be a constraint.”

However, the hyper-charged growth that has buoyed industrial REITs like Prologis in recent years can’t last forever, he notes. Although Pettee maintains a positive outlook on the long-range fundamentals of top-tier industrial REITs, he says it’s unrealistic to assume that the sector will keep up its torrid pace of share-price appreciation. Compared with the overall REIT average, industrial REITs now trade at their widest-ever AFFO and NAV premiums, he says.

Frankel stresses that valuation in the industrial sector has grown more difficult as investors’ heightened expectations have become “imbedded” in low cap rates for industrial properties; Prologis, for instance, has cited cap rates a tad over 5.0 percent. As a result, total returns compared with other commercial real estate sectors might not be as attractive for industrial REITs or the private industrial market, Frankel notes.

Additionally, private investors’ intensified enthusiasm for the industrial sector could spur more development and greater supply, which could then drive down rent growth across the sector, according to Frankel.

But until the e-commerce segment’s share of total retail sales—now hovering close to 10 percent—begins to taper off, vigorous demand for warehouse space should continue. Frankel adds that innovations such as automation, robotics and driverless trucks could generate headwinds for the industrial sector; however, that’s unlikely to arise as a key concern in the near future.